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Energy Secretary Chu was Right, US Gas Prices Need to be Higher

Why would a president want to bring an eminent scientist like Energy Secretary Steven Chu into government? In the hope, one would suppose, that he would speak truth to power.

Sadly, that hope seems to have been dashed in the case of Secretary Chu. In 2008, before becoming part of the cabinet, he had said that as part of the effort to protect the environment and wean the U.S. economy from its energy addiction, “Somehow we have to figure out how to boost the price of gasoline to the levels in Europe.” But earlier this week, at a hearing of the Senate Energy and Natural Resources Committee, Chu caved to political pressure, saying ”I no longer share that view.” Digging himself in deeper, he explained that he and the president felt consumers’ pain at the pump, and were doing everything they could not just to hold the line on gasoline prices, but to reduce them.

To understand why Chu was right the first time, we have to understand that there are three prices for gasoline, not just one.

1. The seller price is what producers receive for the gasoline they produce. The dominant component of the seller price is the price of crude oil. Costs of transportation, refining, and distribution add to the seller price, but they, unlike the price of crude, are relatively stable.

2. The buyer price is what consumers pay at the pump. That, of course, is the one everyone talks about.

3. The true price is the supplier price plus the burden the rest of us bear every time someone burns a gallon of gasoline. The true price includes what economists call negative externalities—the costs of congestion and highway maintenance; the harm from local air pollution and global climate change; and the national security costs of dependence on energy imported from unstable and hostile suppliers. Someone always pays this price, even if not the buyer.

What should be the relationship among these three prices? Ideally, the buyer price should be equal to the true price, and the seller price should be less than that by the amount of the externalities. Instead, in the United States today, the buyer price and the seller price are close to equal, with both of them well below the true price.

Notice that when we say that high gasoline prices are good, we do not mean high seller prices, per se. What we mean is that there should be a large, European-style tax wedge between the seller price and the buyer price. In the United States there is now only the small federal gasoline tax, which Congress has not raised for years. It is no longer high enough even to pay for highways, as it should do. As a result, our highways are either falling apart or draining funds from other parts of the budget.

Whenever buyers pay less than the true price of gasoline (or less than the true price of anything) they are getting a free lunch. We all know who, in Washington, is the party of the free lunch–the Republicans. And, of course, the Democrats. Wholehearted support for the Great Free Lunch Machine is the last bastion of bipartisanship.

Steven Chu should know better. As a physicist, he is surely familiar with the second law of thermodynamics, which is the scientific first cousin to the economic principle that There Ain’t No Such Thing as a Free Lunch. Never was and never will be.

According to a report in the National Journal, Chu told reporters after this week’s hearing that he changed his view from 2008 because of the fragile economy. “There is a real hardship that Americans are suffering at the gasoline pump,” Chu was reported to have said. “The recovery is fragile. Another spike in gasoline prices could put that recovery at jeopardy. So there are many, many reasons why we do not want the price of gasoline to go up.”

Nobel Prize in Physics notwithstanding, Chu gets a D- in economics. Keeping gasoline prices low is not a good fix for the fragile recovery. Yes, any government action that encourages consumer spending will provide some short-term economic stimulus, if stimulus is what you want. Handing out food stamps will give you stimulus. So will tax deductions for second-home mortgages. But if you are committed to stimulating consumer spending, why not do it in a way that encourages people to do something good, as with tax credits for energy-saving home improvements? Short of that, why not at least make your stimulus neutral across categories of goods, as with payroll tax cuts or unemployment benefits? But please, don’t go out of your way to support consumer choices that are actively bad, like burning more gasoline. Don’t let the “fragile recovery” be an excuse for supporting every populist or special interest boondoggle Washington can think up.

The fact is, campaign promises to the contrary, there two good reasons why there is little any administration could do to lower gasoline prices.

First, the candidates always stress drilling more domestic wells and building more pipelines. The Republicans promise lots of these. Obama promises a more measured expansion of domestic production plus lots of alternative energy. The problem is, new oil production, whether from deeper offshore wells, drilling in the far north, or from the Canadian oil sands to which the Keystone XL pipeline would connect, are all high cost oil. Forget the fact that it would be years before they came on line; even after they did so, their production costs are so high that they could do little if anything to bring down the cost of gasoline at the pump.

Second, the campaign promises implicitly assume that the U.S. gasoline market operates in isolation from the world, so that we could bring down domestic oil prices while world oil prices remained high. How is that supposed to happen? Are we supposed to introduce some kind of regulatory gimmickry to force U.S. prices below the world level? The United States uses more than 20 percent of the world’s oil and produces less than 10 percent. Raising domestic production enough to reach self-sufficiency would only add 10 percent or so to global supply, enough to lower the world price a little, but not enough to cut gasoline prices dramatically.

In short, the campaign rhetoric about gasoline prices rests on a double false premise: That bringing down prices should be the goal and that more drilling is the way to achieve it.

That brings us back to those high European gas prices. European governments, in their wisdom, have made the commitment to bring the buyer price of motor fuel into line with its true price. Doing so cuts consumption and puts downward pressure on the seller price. A lower seller price takes money out of the pockets of oil producers, too many of whom are repressive, corrupt, and hostile to our interests. The European approach makes perfect sense. Steven Chu—back when he was plain Dr. Chu—knew that. Does Secretary of Energy Chu still know it, in his heart of hearts? Or has he, like so many before him, completely lost his bearings after too many years inside the beltway?

Centuries ago, under pressure from the inquisition, Galileo recanted his idea that the Earth moves around the sun. Legend has it that as he left the scene of his recantation, bystanders heard him mutter “Eppur si muove,”—“Even so, it does move.” Let’s hope that Secretary Chu finds the courage to restore his reputation with an “eppur” of his own.

By. Ed Dolan

"This post originally appeared on Ed Dolan's Econ Blog at Economonitor.com, and is reprinted here with permission."

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When the price of natural gas was government controlled, many said that the free market would drive up the price, but it fell. The price of natural gas today is falling for the same reason - more supply. Oil responds equally, and as the new technology drives oil, the price will decline.

Alex on May 08 2012 said:

This has to be the most tortured attempt to justify a nonsensical economic theory I can remember!

We can't have any of that nasty old free market determination in our utopian vision, can we?

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